What is the Bootstrap Effect? Merger & Acquisition-Activities and their Influence on Stock Prices


Term Paper, 2017

24 Pages, Grade: 1,7


Excerpt

Table of contents

List of figures

List of tables

List of abbreviations

1 Introduction

2 Mergers & acquisitions at a glance

3 Mergers & acquisitions’ influence on the share price
3.1 Influence of takeover announcements
3.2 Shareholder value approach
3.3 Calculation of the shareholder value

4 The bootstrap effect
4.1 Account of the bootstrap effect
4.2 Appliance of the bootstrap effect
4.3 Consequences for mergers and acquisitions

5 Conclusion

Annex
A-1: Weighted average cost of capital
A-2: Free cash flow.. VI
A-3: Earnings per share and price-earnings ratio

Bibliography

Internet bibliography

List of figures

Figure 1: Rappaport's Shareholder Value Network

List of tables

Table 1: Exemplary calculation of the Bootstrap Effect,

List of abbreviations

Abbildung in dieser Leseprobe nicht enthalten

1 Introduction

In 2016, the global mergers and acquisitions (M&A) activities decreased by about 18 percent compared to 2015. Altogether, 17,369 deals with a value of 3.2 trillion (tn.) US-Dollars (USD) were performed.1

There are numerous reasons to invest and divest in inorganic growth. Organic growth has its limitations, thus acquiring competitors, growing vertically or horizontally as well as accessing new markets are strong motivators to do so. Growing a business is often linked with going public. The decision to be part of the stock market and to perform M&A influences an enterprise’s value for various reasons. Therefore, this paper will examine the question: how do M&A activities influence a company’s stock price and earnings per share (EPS), especially if the bootstrap effect occurs?

To approach this question, the first chapter gives a general overview of reasons, motivators, risks and benefits of M&A. Thereafter, the influence of M&A on a company’s shareholder value and EPS is examined. Then, the bootstrap effect is explained and subsequently illustrated by an exemplary M&A transaction. Afterwards the risks and benefits of bootstrapping and M&A are analysed to consider its usefulness and influence on the share price and EPS.

2 Mergers & acquisitions at a glance

There exist various forms and reasons for M&A. This chapter outlines a general overview of the different forms and investigates the reasons to perform M&A, examining its motives critically.

In M&A there are two roles the related companies are assigned to: the target and the acquirer.2 The transaction is either a merger or an acquisition, also called takeover. A merger combines the acquirer and the target company, forming a new entity. Whereas an acquisition integrates the target in the acquiring company, resulting in the target’s vanishing.3 Depending on the direction of the transaction, three different forms of M&A can be distinguished:4

- Horizontal merger/acquisition
- Vertical merger/acquisition
- Conglomerate merger/acquisition

A horizontal merger is typically a transaction, in which the acquirer buys a target in the same industry e.g. a competitor. If the transaction’s direction is aimed forward or backward in the production chain e.g. a car manufacturer buys a car component manufacturer, the business transaction is called vertical merger. The merge of two unrelated businesses in regards to the industry is a conglomerate transaction.5

The major motivators to merge are the underlying expectation of synergies and the assumption of managers, that the market undervalues the target firm. The second motivator’s main financial gain is to sell the components of the target firm at a higher price than the acquisition price was. The first motivator’s outcome is a higher value (V) of the amalgamation of both firms, due to synergies according to the formula:6

Abbildung in dieser Leseprobe nicht enthalten

Therefore, synergies are:7

Abbildung in dieser Leseprobe nicht enthalten

Formula 1 assumes that the values of firm A (VA) and firm B (VB) are increased due to synergies if they are merged and create firm AB (VA+B). Consequently, formula 2 defines the created synergy as the subtraction of the firms’ single values before the merger from the combined firm’s value.

Synergies occur in different extent and forms. Economies of scale and scope are resulting in savings e.g. for economies of scale, the higher volume of the merged firms needs a larger amount of input goods to create products, thus the unit costs are cut.8 There are strategic benefits, which create new opportunities in regards to technological chances e.g. Procter & Gamble acquiring Charmin Paper Company, resulting in hygiene products created out of the interrelation of the companies.9 Moreover, this is economies of scope or the combination of complementary resources, because the combination of both company’s resources resulted in savings and new opportunities.10 Besides these synergies, monopoly and efficiency gains as well as acquired expertise are accompanying the merger of two firms. Monopoly gains are created by eliminating rivalry within an industry, when one rival acquires the other. Efficiency is increased when duplicated structures of both firms are consolidated or a more efficient board replaces the former management.11

A principal argument for an M&A transaction, especially for a conglomerate takeover is diversification. Positive aspects of diversification are an increased debt capacity and decreased borrowing costs due to the lower risk of bankruptcy.12

Especially, cash rich firms with high surplus are diversifying13 despite the fact that investors do not pay a premium for diversified firms or long-term value is created.14 Instead of running the risk to invest in a non-value-creating acquisition, it is preferable to invest in internal growth or, if there is no opportunity to invest internally, a return of cash in forms of dividends or share buybacks.15 A major reason for diversification is risk reduction due to a distribution of the risk. Shareholders are able to reach risk reduction much easier if they buy shares of different firms. They diversify their own portfolio of shares to reduce risk, thus the diversification by an acquisition has no beneficial effect on shareholders. Moreover, the acquisition could possibly reduce the shareholder value due to the merger costs and increased costs of running a diversified business.16

3 Mergers & acquisitions’ influence on the share price

Besides the mentioned economic motives for M&A, there are several managerial motivations to perform takeovers. Generally, managers of larger firms are usually experience compensation based advantages, thus growing the company inorganically increases the managers’ salaries faster compared to organic growth.17 This could lead to a conflict of interests, because managers of large firms earn more money but hold very little fractions of the company’s stocks. Therefore, the risk of a financially inefficient merger has more influence on the shareholder value than on the manager’s compensation. Managers’ overconfidence in their own abilities to integrate every takeover successfully could lead to a decrease of shareholder value, but could cause a gain for the managers’ income.18 Besides the increasing company size to increasing manager income relation, sometimes the compensation is based on stock performance e.g. EPS. This can cause managers to merge firms, despite the fact that there is any economic growth or value creation but an increase in the EPS or even share price.19 This so-called “bootstrap effect” occurs when the investors respectively the market is fooled and overvalues the company.20 This effect is discussed later on.

3.1 Influence of takeover announcements

A company planning to take over another firm has to announce the tender offer publicly. The sheer announcement has a traceable effect on both companies’ share prices. The share price of large acquirers in a merger decrease on average when the offer is announced, particularly if the target is a publicly listed company (one reason may be the mentioned conflict of interests).21,22 Literature and studies concerning this topic are not overall consistent. However, target companies’ shareholders involved in mergers or takeovers are gaining significant cumulative abnormal returns, sometimes even prior to an announcement due to leaked information.23

A study and extensive literature review of Kumar and Panneerselvam24 found positive abnormal gains for both firms involved in the transaction, especially in the period encompassing the announcement. Highest positive gains have the target firms included in a merger followed by the acquirers. They are followed by the gains of acquirers involved in an acquisition transaction. This is in contrast to the before mentioned decrease25, but can be associated to different data sets respective analysed periods and firms. Averaged, M&A are value-creating activities but stockholders of the acquirer receive more gains compared to stockholders of the target firms in acquisitions. The outcome for mergers is vice versa.26

Concluding, M&A transactions are potentially beneficial for shareholders, but it depends on each transaction’s circumstances and managers involved. The announcements and linked share price variations are opportunities for risk arbitrageurs27 but long-term value-oriented management better focuses on post-merger integration and a successful realisation of the anticipated synergies to create shareholder value.28

3.2 Shareholder value approach

The enterprise value of a firm is calculated as the market value of equity plus the debt minus the cash out of marketable securities. The enterprise value aims to assess the value of the business’ assets.29 This balance sheet based calculation is not suitable to calculate shareholder value, because book values are not market values. Furthermore, an investor respectively shareholder is interested in future profits and surplus of the company. The expectation is future positive cash flows in forms of increased stock price and dividends.30

The shareholder value approach (SVN) is a management approach developed by Rappaport to maximise shareholder value.

This approach is based on discounted cash flow calculation of investments, as often used for net present value calculation. Rappaport31 extends this calculation to value a business or parts of it to the strategic planning and controlling of management decisions. Therefore, the approach evaluates both, investments in forms of acquisitions and strategic decisions of the management, contributions to shareholder value. It is an ongoing company valuation and success monitoring.32 Figure 1 shows the shareholder value network and the influence of management decisions on value drivers, which contribute to the valuation components ultimately creating shareholder value.

Figure 1: Rappaport's shareholder value network33

Abbildung in dieser Leseprobe nicht enthalten

The network is based on the management dicisions concerning operations, investment and financing, which are conducive to value creation and result in the value drivers.

[...]


1 Mergermarket, “Global and regional M&A: Q1-Q4 2016,” [http://www.mergermarket.com/pdf/MergermarketFinancialLeagueTableReport.Q42016.pdf], accessed April 2017, p. 3.

2 Berk, J., and Peter DeMarzo, Corporate Finance, 3rd ed. (Boston, MA: Pearson, 2014), p. 931.

3 Pike, Richard, and Bill Neale, Corporate Finance and Investment: Decisions & Strategies, 5th ed. (Harlow: Financial Times Prentice Hall, 2006), pp. 542-543.

4 Berk, J., and Peter DeMarzo, Corporate Finance, p. 933.

5 Brealey, Richard A., Myers, Stewart C., and Alan J. Marcus, Fundamentals of Corporate Finance, 3rd ed. (McGraw-Hill Higher Education, 2001), p. 572.

6 Pike, Richard, and Bill Neale, Corporate Finance and Investment: Decisions & Strategies, p. 548.

7 Ross, Stephen A., Westerfield, Randolph W., and Jaffrey Jaffe, Corporate Finance, 6th ed. (Boston, MA: McGraw-Hill/Irwin, 2003), p.823.

8 Berk, J., and Peter DeMarzo, Corporate Finance, p. 935.

9 Ross, Stephen A., Westerfield, Randolph W., and Jaffrey Jaffe, Corporate Finance, p. 825.

10 Brealey, Richard A., Myers, Stewart C., and Alan J. Marcus, Fundamentals of Corporate Finance, pp. 574-575.

11 Berk, J., and Peter DeMarzo, Corporate Finance, pp. 935-936.

12 Ibid., p. 938.

13 Ross, Stephen A., Westerfield, Randolph W., and Jaffrey Jaffe, Corporate Finance, p. 834.

14 Brealey, Richard A., Myers, Stewart C., and Franklin Allen, Principles of Corporate Finance, 10th ed. (Boston, MA: McGraw-Hill/Irwin, 2011), p. 798.

15 Rappaport, Alfred, “Ten Ways to Create Shareholder Value,“Harvard Business Review, September 2006, https://hbr.org/2006/09/ten-ways-to-create-shareholder-value, accessed July 2017.

16 Berk, J., and Peter DeMarzo, Corporate Finance, p. 938.

17 Pike, Richard, and Bill Neale, Corporate Finance and Investment: Decisions & Strategies, p. 551.

18 Berk, J., and Peter DeMarzo, Corporate Finance, p. 940.

19 Pike, Richard, and Bill Neale, Corporate Finance and Investment: Decisions & Strategies, p. 551.

20 Brealey, Richard A., Myers, Stewart C., and Franklin Allen, Principles of Corporate Finance, p. 799.

21 Berk, J., and Peter DeMarzo, Corporate Finance, pp. 939-941.

22 Wong, Anson, and Kui Yin Cheung, “The Effects of Merger and Acquisition Announcements on the Security Prices of Bidding Firms and Target Firms in Asia,” International Journal of Economics and Finance 1, no. 2 (August 2009), p. 275.

23 McGowan, Carl B., and Zunaidah Sulong, “A Note On The Effect Of M&A Announcements On Stock Price Behavior And Financial Performance Changes: The Case Of Arab Malaysian Bank Berhad And Hong Leong Bank Berhad,” International Business & Economics Research Journal 7, no. 9 (September 2008), p. 22.

24 Kumar, B. Rajesh, and S. Panneerselvam, “Mergers, Acquisitions and Wealth Creation: A Comparative Study in the Indian Context,” IIMB Management Review 21, no. 3 (2009), pp. 241-242.

25 Brealey, Richard A., Myers, Stewart C., and Franklin Allen, Principles of Corporate Finance, p. 813.

26 Ibid., p.

27 Berk, J., and Peter DeMarzo, Corporate Finance, p. 943.

28 Rappaport, Alfred, “Ten Ways to Create Shareholder Value“.

29 Berk, J., and Peter DeMarzo, Corporate Finance, p. 28.

30 Prangenberg, Arno, Müller, Matthias, and Manuela Aldenhoff, “Der Shareholder-Value-Ansatz,“Arbeitshilfen für Aufsichtsräte 9, 4th ed. (Düsseldorf: Hans-Böckler-Stiftung, 2005), p. 9.

31 Lohr, Burkhard, Bewertung bauausführender Unternehmen: Ein ganzheitliches entscheidungsorientiertes Konzept (Munich: Herbert Utz Verlag, 2001), p. 189.

32 Ibid.

33 Graphic based on Rappaport, Alfred, Creating Shareholder Value: A Guide For Managers and Investors (New York, NY: The Free Press, 1998), p. 56.

Excerpt out of 24 pages

Details

Title
What is the Bootstrap Effect? Merger & Acquisition-Activities and their Influence on Stock Prices
College
The FOM University of Applied Sciences, Hamburg
Grade
1,7
Author
Year
2017
Pages
24
Catalog Number
V536597
ISBN (eBook)
9783346145499
ISBN (Book)
9783346145505
Language
English
Tags
M&A activities influence on stock prices - Bootstrap Effect, Bootstrap Effect, Bootstrap, M&A activities, International Investment & Controlling, International Investment, International Controlling, Master of Business Administration, MBA, FOM, FOM Hamburg, FOM Assignment, FOM Hausarbeit, Hausarbeit, Assignment, FOM MBA, Finance, International Finance, Betriebswirtschaft, Betriebswirtschaftslehre, M&A, share price, share, stock, Mergers & acquisitions, takeover, shareholder value, shareholder, Earnings per share, price-earnings ratio, P/E ratio, Free cash flow, Weighted average cost of capital, WACC, RAPPAPORT, SHAREHOLDER VALUE NETWORK, M&A transaction, EPS, synergies, takeover announcement, 3.2 Shareholder value approach, balance sheet, balance, Bilanz, Unternehmensbewertung, Firmenbewertung, Shareholder value added, cash flow, cash flow valuation, ROI, ROE, FCF, Seminararbeit
Quote paper
Florian Beyer (Author), 2017, What is the Bootstrap Effect? Merger & Acquisition-Activities and their Influence on Stock Prices, Munich, GRIN Verlag, https://www.grin.com/document/536597

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